Fed plans to overhaul the regulation of foreign subsidiaries

Large foreign banks may be required to roll-up their US bank and nonbank subsidiaries under a top-tier US intermediate holding (IHC) under proposals unveiled by Federal Reserve (Fed) Governor Daniel K. Tarullo on 28 November 2012.

The move would allow US regulators to apply domestic capital and liquidity standards to subsidiaries of large foreign banks, including capital and liquidity buffers and surcharges. Enhanced prudential standards for systemically important US banks would also apply to IHCs, including:

stress-testing

risk management and governance requirements

single counterparty credit exposure limits

early remediation requirements.

The proposal will capture all ‘large’ foreign banks operating subsidiaries in the US – probably those with $50 billion in US assets or more. It is primarily directed at foreign banks with sizeable broker dealer and asset management activities in the US. Nonbanks are also captured as many foreign banks operate unregulated subsidiaries in the US.

In terms of smaller banks, Tarullo suggests that it’s “an open question” whether they will be required to establish IHCs. It is likely that the Fed will preserve the right to apply higher standards or introduce structural reforms to small foreign banks on a case-by-case basis. Foreign banks with only nonbank subsidiaries will see the biggest changes. They will be required for the first time to establish a US holding company structure if they want to continue to operate in the US.

These proposals could seriously circumscribe attempts by foreign groups to streamline capital requirements when complying with Basel III requirements across multiple jurisdictions. It is unclear how conflicts between the US capital and requirements and those that apply at the consolidated group level would be resolved, where material differences exist.

Tarullo’s proposal stops short of a complete subsidiarisation model—foreign branches would not have to be rolled-up into a US holding company. This gives foreign groups a degree of flexibility to choose among the structures that they believe promote maximum efficiency at the consolidated level but is still a significant departure from the traditional approach.

But foreign banks using a branching model would also face certain additional requirements – it is not yet clear what those might be. Tarullo said that foreign branches operating in the US will be subject to new liquidity standards in the future reflecting the Fed’s concerns about the shift over the past decade or so to a ‘dollar funding model’ used by many foreign banks, whereby branches are used to borrow US dollars to upstream to their parent organisations.

Financial stability hawks may fret that banks with different balance sheets, business models and risk profiles will be required to adopt a uniform IHC structure. In defending the proposals, Tarullo specifically rejected the traditional case-by-case approach to structure and regulation as involving, in his judgement, the “worst of both worlds” – “an ongoing intrusiveness into the consolidated supervision of foreign banks by their home-country regulators without the ultimate ability to evaluate those banks comprehensively or to direct changes in a parent bank's practices necessary to mitigate risks in the United States”.

The Fed has a number of concerns that appear to be driving this new approach.

Firstly, G-SIFIs. Tarullo noted that 23 foreign banks have at least $50 billion in US assets - the threshold which triggers higher capital and liquidity provisions under the Dodd-Frank Act. This compares with only 25 domestic US banks which also exceed this threshold. So there is a greater concentration of third-party assets at fewer, large foreign banks whose systemic importance rivals their US peers in many areas. For example, five of the ten largest US broker-dealers are in foreign hands and ten foreign banks now account for more than two-thirds of foreign bank third-party assets held in the US, up from 40% in 1995.

Secondly, interconnectedness and contagion considerations. Tarullo notes the changing nature of foreign banks activities and the shift away from commercial lending to risky capital markets activities that are more complex and create more interdependencies / interconnections with other large US and non-US financial institutions.

Finally, harmonisation versus differentiation in regulatory approaches. Tarullo advocates a pragmatic approach to harmonisation, suggesting that it is “not clear that we should aim towards extensive harmonisation of national regulatory practices related to foreign banks” given that foreign banks’ activities create different risks in host countries. The fact that several national authorities (UK and Switzerland) have already introduced their own policies to fortify the resources of internationally-active banks within their borders is evidence of this movement.

Tarullo said that the Fed’s new regulatory approach to foreign banks will be formally announced before Christmas with “all-important details” currently under discussion at the Fed’s Board of Governors. For more details see our FS Regulatory Brief: Fed to raise requirements for foreign banks.

Some commentators worry that these developments represent a trend towards regionalisation of global banking, which could be damaging for both banks and the real economy. It may also signal less international cooperation amongst regulators in the future. There remains a fundamental lack of trust amongst regulators as to the soundness of regulation in other countries, and an unwillingness to rely on each other in a crisis. The Fed’s latest move demonstrates that it doesn’t want to risk relying on other regulators to successfully resolve an institution where its failure could have a significant impact on the financial stability in the US, so they are resorting to ring-fencing. The UK ring-fencing proposals are driven by a similar fear - of being unable to control the situation of a failing institution if a foreign regulator has the lead role. A combination of more uniform capital and liquidity standards, resolution regimes and guarantee schemes supported by effectively coordinated international supervisory relationships could address these issues. The Basel Committee and FSB initiatives have made significant strides over the past couple years – but disparate legal and regulatory regimes, regulators fears and local political considerations all throw up barriers. Perhaps when it comes to resolution the best we can hope for at present is that they find ways to stay out of each others’ way.

In spite of the globalisation of financial markets in recent decades, banks continue to live internationally but die nationally. On 10 December 2012, the Bank of England and the Federal Deposit Insurance Corporation (FDIC) published a joint paper setting out some operational strategies for resolving globally active systemically important financial institutions (G-SIFIs).

The regulators focus on the "single point of entry" approach to resolution, where resolution powers are applied to the top of a group by a single national resolution authority. They recognises that, depending on the structure of an organisation, sometimes resolution may best be achieved through a “multiple point of entry” approach but have put that in the too difficult box at present.

The paper presents post-crisis strategies for resolving failed global systemically important financial institutions. The UK and the US have developed resolution strategies intended to take control of the failed company at the top of the group, impose losses on shareholders and unsecured creditors (through the use of bail-in debt etc.), and remove top management, holding them accountable for their actions.

The paper presents comparative analysis between the UK and US legislative frameworks for this approach. It considers the US Dodd-Frank Act and the UK Banking Act 2009, the recommendations of the Independent Commission on Banking (aka Vickers report) and the proposed EU Recovery and Resolution Directive (RRD).

This paper offers a useful comparison of the local regimes, and more cooperation between international regulators is always to be welcomed. But one is left with the feeling that UK and US regulators are both still more intent on justifying their respective approaches than adopting a common one.

References:

ECB gets behind the Recovery and Resolution Directive

The ECB fully supports the development of a common recovery and resolution framework for EU banks and large investment firms as outlined in the European Commission’s Recovery and Resolution Directive (RRD) proposal published in June. The RRD proposes a framework which would give authorities sufficient powers to quickly intervene to recover or resolve a failing financial institution within a short timeframe while avoiding wider contagion in the financial system or economy.

The ECB suggest that a resolution framework needs to promote not only the continuance of financial stability across European financial markets but also ensure the functioning of the single market itself. The development of common support tools to manage the failure of financial institutions is essential in this regard. The ECB is particularly keen on the propagation of robust recovery and resolution plans at banks and investment firms, as well as the use of a bridge bank, bail-in debt, sale of business and other asset separation tools.

Clearly negotiations on the single supervisory mechanism have somewhat overshadowed the RRD in recent months. However, the ECB believes the proposed Directive is a “very important step towards an integrated resolution framework” for the EU (which would form another key facet of the EU ‘banking union’) and should be “adopted rapidly”.

However, the ECB does not want to wait for this proposal to be adopted before taking the next steps. The ECB wants the EC to urgently present a separate proposal for an independent European Resolution Mechanism, including aspects of a common European Resolution Fund. This Fund would, as a minimum, be financed by the financial institutions.

This will be a divisive issue but one which must be addressed soon. The ECB’s new supervisory mandate will be undermined if national authorities are required to pick up the tab for bailing out or resolving failed banks in the future, even if indirectly via the European Stability Mechanism. A common resolution mechanism will mutualise the future costs of bail-outs and give pan-European authorities leeway to make the difficult and unenviable decisions associated with crisis management.

EC (2012) Proposal establishing a framework for the recovery and resolution of credit institutions and investment firms (2012/0150 (COD).

International regulators agree to cooperate on OTC regulations

International regulators agreed to consult with each other before making any final decisions as to which derivative contracts will be subject to mandatory clearing, following a meeting of eight international regulators on 28 November 2012.

Regulators from Australia, Brazil, the EU, Hong Kong, Japan, Ontario, Quebec, Singapore, Switzerland and the US all agreed to work closely together to address potential conflicts, inconsistencies and duplicative requirements within their OTC derivative rules. Specifically regulators vowed to work together:

developing concrete and practical solutions to any conflicts of rules that may arise

identifying inconsistent or duplicative requirements

identifying gaps and reducing the potential for regulatory arbitrage.

Regulators will consider adopting transitional implementation measures for certain jurisdictions that are unable to implement OTC derivatives reform on time to mitigate the dangers of regulatory arbitrage for market participants, intermediaries and infrastructures. The regulators also set out areas of further exploration. They discussed different approaches to regulating persons, transactions and infrastructures in relation to cross-border activity when more than one set of rules applies.

G-20 leaders made a commitment to ensure that all standardised OTC derivatives were (1) traded in exchanges or electronic platforms (2) cleared through central clearing parties, and (3) reported to trade repositories by the end of this year.

Most jurisdictions will have final legislation in place governing OTC derivative reforms by the end of this year. But it will take some time for the regime to be fully operational where there is a sufficient number of CCPs providing clearing services to traders, links to other market infrastructures are embedded, new organised trading platforms are developed, reporting standards to trade repositories are finalised and uncertainty regarding the cross-border application of regulatory frameworks is addressed.

The success of the new regime will rest on addressing these issues. Greater international cooperation will help.

The changing world of central banking

Before the crisis, central banking was a pretty dull business. With the nastiest of the 1970s stagflation a distant memory, central bankers were confident in their price stability objective as a means of keeping the economy ticking over and the effectiveness of their monetary tools to support this.

Things changed quickly as a result of the crisis: central banking is in flux, monetary tools are being re-considered and central bankers are now amongst the most powerful individuals setting the agenda for global economic recovery.

Central banks are now seeing fundamental changes in their role and operational scope as they are called upon to work alongside governments and supervisors in moving to a more regulated and interventionist approach to the management of financial stability. These changes are live and ever evolving. For example, issues about the independence of the Bank of Japan are currently exercising voters in their forthcoming elections; and European politicians gave the ECB unprecedented monetary and supervisory powers over Eurozone banks last week.

All central banks are facing the urgent need to reassess their strategy and place within the wider regulatory and economic environment but there is no one way for central banks to deal with these challenges, particularly when strategies and objectives are profoundly affected by the economic circumstances and politics of the central bank’s home country.

Our Central Bank team have prepared a paper, Project Blue: Forging the central bank of the future, on these and other issues on the future of central banking. The paper considers the implications of global and local instability, the rise of state-directed capitalism and the rise and interconnectivity of the emerging markets and key Project Blue drivers which are likely to have the most far-reaching impact on central banks.